What is normative accounting?

Andrew Watson
May 28, 2021

In a few words, it's simply an alternative financial view of a company or a scenario applying different accounting treatment. Think of it as similar to an analysts' report, except prepared in a standard way that everyone can apply depending on the point of view from which you’re looking at a company or a scenario.

So if I'm the CEO of BP and I'm asked to show my investors our net zero transition program, I can apply a normative accounting treatment that shows net zero investments as assets not costs. 

Or if I'm a member of society that wants to hold BP accountable for its net zero targets then, using public data, I can create a set of normative financial statements from the outside using accounting treatment that recognizes BP's climate liabilities and whether it is meeting its commitments to be on the way to net zero by 2030. 

We call it an alternative fair view.

In more words

Bill Gates is always our start point in explaining the problem that normative accounting fixes.

'The portion of the world's economy that doesn’t fit with the old model just keeps getting larger. That has major implications for everything from tax law to economic policy to which cities thrive and which cities fall behind, but in general, the rules that govern the economy haven't kept up. This is one of the biggest trends in the global economy that isn't getting enough attention.’  

Bill Gates, reviewing Capitalism Without Capital: The Rise of the Intangible Economy

The economy has clearly changed. Intangibles dominate the global economy but accounting practice hasn’t kept up. As a result financial statements don’t show what is actually creating value (intangible assets) or those things that could lose value (intangible liabilities, such as climate risk).

This combination means that today's financial statements are showing a substantially negative view of an entity's assets and equity on its balance sheet and of its profitability. And by not recognizing intangible liabilities they're also showing a materially positive view of an entity's true liabilities, equity and profitability. 

In other words what's being reported today is nowhere near the commercial reality. 

Change in accounting standards or accounting practice won't happen. So what can be done now to show a true picture of the commercial reality of an entity or a scenario? The answer is normative accounting for intangibles. 

Normative accounting's premise is that value is subjective to the user. Having identified the user of the accounts and the decision that the user intends to make, the accounting treatment then follows. It means that there are many alternative fair views of an entity or a scenario each with different accounting treatments. 

In showing these alternative fair views, Rethinking Capital uses existing technical accounting and International Accounting Standards. That's the beauty and simplicity of normative accounting for intangibles - it really is just …well ...accounting. 

Applications

We've created two applications of normative accounting for intangibles to solve today's specific economic and social imperatives. 

The first is to enable bank lending to SMEs, including those that will create the breakthrough new energy and other technologies that will replace fossil fuels and enable a new green economy. By properly recognizing intangibles, assets and equity increase by at least three to four times and profits by at least two to three times. The financial position is so transformed that banks have already been able to lend to these companies, whereas previously they fall well below lenders' ratings.

The second is in decision-making relating to the transition to net zero. This application uses the balance sheet as the primary resource for net zero decision making and reporting. 

Current accounting practice looks at net zero innovations and sees them as a cost. Effectively a penalty. The penalty is immediate and certain. And the more that is invested, the higher the penalty. This accounting treatment is upside down and illogical. 

Normative accounting for intangibles looks at these costs and instead recognizes that these are actually investments into an intangible asset, that asset being the social license. The condition for this asset treatment is that the entity also recognizes a quantified contingent liability to reduce its emissions in line with its own stated commitment to transition (net zero by 2040 for example).

Practical application to Danone

At the Global Solutions Initiative's 2021 Annual Summit, we explained the real world problems created by the failure of accounting to keep up using the example of Danone. 

Under Emmanuel Faber, Danone seriously committed to innovate and lead the charge to become a sustainable business. But like most all companies, Danone's accounting practice writes off its innovations as a cost, so the transition is invisible in its financial statements. This accounting effect is made worse by Danone's courage to invest into the net zero transition and other social responsibilities, all of which are also treated as a cost.

The result is a substantially negative accounting view and of a business perceived to be failing both financially and socially. The inevitable outcome was investor pressure and the exit of a courageous CEO.

Whereas the actual financial reality of Danone is of a business building asset value for the long term. Normative accounting would properly recognise all of these innovations as assets on the balance sheet, increasing assets and shareholder equity and profits. It would also show that Emmanuel Faber was driving to build new asset foundations and strongly investing into its social license. 

We were too late to save Emmanuel Faber. We may be too late to stop his replacement from putting the brakes on its progressive social program which he must inevitably do to keep him from the same fate. 

But if we can get normative accounting to adoption at scale, it will remove the fear from other courageous CEO's committed to the transitions that society so desperately needs.

Andrew Watson

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